If you are a SaaS business owner, you must read this article to know:
- Why Accounting GAAP Financial Statements Don’t Work For SaaS?
- Accounting for SaaS Companies
The world economy has shifted from an industrial to a knowledge-based economy. Such a transition has led to an increase in the number of SaaS-based firms across the globe.
Though such firms have made the day-to-day tasks for the B2B segment much easier through their SaaS offerings. However, such firms have led to a dilemma for the finance and accounting firms.
The dilemma is that SaaS firms use accounting GAAP principles to prepare their financial statements including income statements and balance sheets for tax reporting purposes. However, GAAP-based financial statements fail to capture a true and fair view of a SaaS-based firm.
This is because the manner in which incomes and expenses are recognized for a SaaS business vary significantly as compared to an industrial business.
For instance, a SaaS-based firm invests significantly in intangible capital like innovation, advertising, information technology, human capital, and customer relations. Further, such firms showcase the intangible capital investment as expenses in their income statement.
This is unlike a material-intensive firm that invests a significant amount of capital on tangible assets like plant and equipment, land and building, and machinery. Also, such firms showcase tangible capital investment as assets in their balance sheet and capitalize such assets over their lifetime in the income statement.
Thus, intangible-intensive firms like SaaS are likely to showcase high volatility in their revenues and cash flows using the accounting GAAP principles.
For instance, during their initial years, SaaS-based firms may suffer losses as their intangible investments are showcased as expenses.
In addition to this, the earnings of such firms are almost negligible. However, when these firms reach their growth phase, they have significant earnings and lower intangible investments.
Free 30-Min Strategy Session
By the end of this Strategy Session, you will have a clear understanding of the next steps you can take for your business to take advantage of the tax deductions you are missing out on.
Thus, as per GAAP, the future benefits are highly uncertain in the case of intangible-intensive businesses relative to tangible investments.
This clearly indicates that the SaaS income statement and balance sheet prepared using accounting GAAP principles do not give a true and fair view of the SaaS business. Thus, SaaS businesses have to use different metrics to measure performance.
This is to ensure that the financial statements are of the highest quality and can be relied upon by various stakeholders including investors.
In this article, we are going to look at the reasons why SaaS companies are struggling with financial reporting. In addition to this, we will see how Accounting GAAP is different from the key SaaS metrics to measure the operating performance of a subscription-based business.
Why Accounting GAAP Financial Statements Don’t Work For SaaS?
As per research, accounting earnings for intangible-intensive companies are practically irrelevant. This is because the existing financial accounting model fails to consider the following aspects of a SaaS-based business relative to a material-intensive business.
I. Non-Capitalization of Assets Balance Sheet
The balance sheet of a material-intensive business showcases the fair value (historical value) of the tangible assets that help in generating revenues for the business. Such assets include fixed assets like plant and equipment, land and building, machinery, etc.
Further, these productive assets are physical in nature and are the ones that the company owns. Also, such physical assets are located within the material-intensive business.
For instance, General Electric had Property, plant, and equipment worth $15,609 Million as of December 31, 2021. It comprised of Land, Building, Machinery and Equipment, Leasehold Costs, and Under-Construction Manufacturing Plant.
Now let’s consider the balance sheet of an intangible-intensive business like Salesforce. It showcases assets that are intangible in nature. Further, the ecosystems at some subscription-based businesses are beyond the confines of the business.
For instance, Salesforce CRM had Property, plant, and equipment worth $2,815Million as of December 31, 2021. It comprised of Computers, equipment, and software; Land; Building; Furniture and fixtures; Leasehold improvements; Property and Equipment. Note that the computers, equipment, and software also comprised data center facilities and cloud computing platforms offered by third parties.
This showcases that the intangible investments of a SaaS-based business and the factories and buildings of an industrial business serve a similar economic purpose. However, in the case of a SaaS-based business, investments in intangible assets are not capitalized. This is despite the fact that such intangibles act as building blocks for the SaaS business. In fact, such investments are treated as expenses in the income statement.
As a result, business owners and other stakeholders like investors cannot consider earnings reported in GAAP balance sheets as a key metric while undertaking key strategic decisions.
They have to rely on Pro-forma balance sheets in order to get meaningful information about the financial position of a business. For instance, using the Pro-forma balance sheet, investors may calculate metrics like Net Cash from Operations and quick ratio to know whether the business is moving towards a cash crunch.
II. Treating R&D As An Expense Rather Than An Asset
The income statement of a material-intensive business showcases operating expenses like manufacturing costs and non-operating expenses like depreciation. The operating expenses of material-intensive businesses help in meeting expenses related to the day-to-day operations or expenses related to manufacturing.
The non-operating expenses like selling and distribution, administrative expenses, etc. are the expenses that are not directly related to the manufacturing activity. These expenses are incurred to run activities apart from the operating activities of a business.
In addition to this, the income statement of a material-intensive business showcases the cost at which its fixed assets like plant and equipment are capitalized.
For instance, the operating expenses of General Electric as of December 31, 2021, included the Cost of Equipment Sold worth $31,399 Million and the Cost of Services Sold worth $22,497 Million. In addition to this, the income statement of GE also showcased depreciation and amortization of its Plant and Equipment
Now let’s consider the income statement of an intangible-intensive business like Salesforce. It showcases research and development as an expense in the income statement as per accounting GAAP.
However, such accounting treatment does not showcase a true and fair view of the SaaS operating performance. The research and development cost is an investment that has a future value for a SaaS business. This means it has the attributes of a fixed asset that generates economic benefit for the business in the near future. Though, the total amount is invested at present.
But, as per accounting GAAP, research and development are showcased as an expense in the income statement of a SaaS business.
Note that in the initial years, a SaaS business makes huge investments with negligible returns. As a result, it suffers huge losses in its initial years. However, in its growth phase, a SaaS business generates huge profits or earnings with relatively less investment in research and development.
Thus, in both scenarios, the income statement does not showcase the SaaS business’ true value.
Likewise, a SaaS business in its initial phase has a huge amount of sales and marketing expenses. This is because it spends huge amounts of money on sales and marketing personnel, digital advertisement, and other promotional methods in order to generate sales for its products. As a result, a SaaS business may suffer losses in its initial phase. However, in its growth phase, it may generate huge earnings with relatively fewer sales and marketing expenses.
As a result of an increase in intangible capital investment, SaaS-based firms witness a significant increase in research and development (R&D) expenses, market-to-book ratios, and selling, general, and administrative (SG&A) expenses over time.
Due to the increased investment in intangible assets, the income statements of SaaS-based firms showcase huge losses in the initial years of investment. What this means is that the intangible-intensive firms are likely to showcase high volatility in their revenues and cash flows.
This is unlike the material-intensive industries that continue to operate at the existing level of tangible inputs in their production function. This is because such firms are in the mature phase of their lifecycle. As a result, such firms do not change their production function unless breakthroughs in production technology occur.
III. Failure To Account For Increasing Returns On Intangibles
The principal component that creates value for intangible-intensive companies is the increasing return to scale on intangible investments.
The intangible assets in the case of a SaaS-based business enhance as more users use the underlying product or service. For instance, the value of a CRM SaaS application is as more users start using the application.
How? Well, the benefits that the existing customers receive increase when more new users start using the CRM application.
In other words, each new user of the application accrues more benefits for the existing users. This happens as a result of a “network effect”. That is, as more and more users start using the application, the application’s value increases. This happens because every additional dollar of revenue generated from additional customers means more earnings. And more earnings per dollar create more value for shareholders of the CRM application.
Note that modern SaaS-based businesses depend on intangible assets like human capital to grow their business. However, the traditional accounting rules fail to account for the impact that such businesses have as a result of increasing returns to scale on their digital platforms.
These digital platforms invest more in intangible assets like servers to grow their user base. This is unlike a traditional business that invests more in office space or manpower to handle more clients.
However, the current financial accounting model does not take into account such an effect or appreciation in the value of an intangible asset with increased use.
IV. Failure To Account For True Cost Of Revenues
A material-intensive business as well as a professional services firm recognizes the cost of delivering services to the customers in the current period in the books of accounts. For instance, the professional fee or wages for delivering services in the current period are recognized in the income statement.
Further, such expenses are matched to the revenues generated in the current period. As a result, the income statement of material-intensive and professional services firms showcases accurate earnings generated in the current period.
This is in contrast to the revenues recognized in the case of SaaS-based businesses. Intangible-intensive businesses typically expense their investments in intangibles as incurred. This is irrespective of when their associated benefits materialize. Thus, the immediate expensing of intangible investments increases the volatility in expenses. Such increased volatility leads to a mismatch between corresponding revenues and expenses.
For instance, a SaaS-based firm recognizes the cost of building the application as an expense in its initial years. This is when such a firm has little revenue. However, the firm earns a huge amount of revenue when its application becomes established. Also at that point in time, the SaaS firm has fewer expenses to report. In both phases, the calculation of earnings does not reflect the true costs of revenues.
Thus, increased revenue and expense volatilities along with a decline in the matching of corresponding revenues and expenses increase the volatility in earnings. And volatile earnings are less informative for predicting a firm׳s future fundamentals. This means that the intangible-intensive businesses display fewer earnings relevance.
Accounting for SaaS Companies: Accounting Rules For SaaS Companies
I. Identification of the Type of Arrangement
The accounting rules for SaaS companies with regards to revenue and cost recognition are different relative to those followed by software licensing companies. That’s because the nature of the underlying transactions in the case of SaaS firms is different from that of the transactions of the traditional software licensing companies.
Note that the business selling traditional software treats the sale of a software license as a sale of a product for accounting purposes. However, a SaaS business treats the sale of a license as a sale of a service provided over a period of time.
This happens because, in the traditional software licensing arrangement, the customer gets the right to use the software on its own computers. But in a SaaS arrangement, the customer purchases a hosted service based on proprietary software. It does not get a copy of the software to use on its own.
In the case of a SaaS arrangement, there are scenarios when customers sign a software license agreement and install interface software on their own computers. But when the fundamental aim of such interface software is to help customers use the hosted software services, then it is still treated as a SaaS arrangement for accounting purposes.
In addition to the above arrangements, there are other software arrangements as well. In such arrangements, customers receive a copy of the complete underlying software and license rights to use the software on their own computers. This is in addition to the right to use the hosted version of the software.
In such scenarios, the arrangement is considered as a licensing arrangement for accounting purposes only if the following conditions are satisfied.
- The customer has the contractual right to possess the software at any time during the hosting period without any significant penalty;
- It is feasible for customers to either run the software on their own hardware or contract with another party unrelated to the vendor to host the software.
Note that it is important for a business to determine whether the type of customer arrangements has been treated as licensing or SaaS arrangements for accounting purposes. This is because the customer arrangement determines the accounting rules that a business must apply for recognizing revenues and costs.
II. Recognition of Revenues
Typically, traditional software licensing companies can recognize a significant portion of the software fee as revenues in their books of accounts when such software is delivered to the customer.
However, SaaS companies need to recognize fees over the term of the contract term or the estimated life that the customer is expected to use the hosted service.
Furthermore, in the case of SaaS, the periodic fees pertaining to the ongoing usage of the hosted service are recognized as revenue over each periodic hosting term. Such fee is recognized on a straight‐line basis.
In addition to the primary services, SaaS firms may also provide other services both during and after the set‐up period. The fee related to such other services is recognized either when the services are performed or is deferred and recognized over each periodic hosting term. Such fee is recognized on a straight‐line basis.
As per the new accounting rules for SaaS firms, companies first need to identify other services having stand‐alone value. Then they need to allocate the total arrangement consideration on a pro-rata basis between the other services and hosted services.
Such allocations are based on the SaaS firm’s selling price estimates determined considering both the services are sold independently.
These new rules provide more flexibility to the SaaS companies when pricing services. The SaaS firms will now be able to price the hosted services based on market conditions and not as per accounting requirements.
Also, the new accounting requirement of using estimated selling prices will require SaaS firms to analyze the nature of the other services as well. Such an analysis will help them to determine the services having a stand‐alone value.
II. Recognition of Costs
SaaS companies incur two types of costs from an accounting perspective. These include the costs to develop and maintain the SaaS software and direct customer costs.
SaaS software development costs are either capitalized over the software’s expected life or are expensed as incurred. A SaaS firm must capitalize on the software development costs if it sells the developed software as a license for use on a customer’s own computers. However, a SaaS firm must expense the software development and maintenance costs if the developed software is solely used internally to provide hosted services to customers.
This means that software licensing companies capitalizing on software development costs must follow one set of accounting rules. Whereas SaaS companies are must follow different accounting rules if they do sell the software as a separate license.
Likewise, SaaS companies can either expense the direct customer costs as incurred or defer and recognize as the related revenue based on the accounting policy they choose to implement.
Thus, SaaS companies must consistently follow the accounting policy that they choose to implement. Most of the SaaS firms defer direct customer costs and recognize them over the period during which they recognize revenues.
But such a practice can result in increased bookkeeping for SaaS firms. For instance, costs related to the other services with stand‐alone value should be recognized as and when those services are performed. Whereas, the costs related to set‐up services not having a stand-alone value can be deferred and recognized over the expected period of customer use of the hosted service.
Thus, SaaS firms face immense challenges when determining how to price their products and services. This is because of their unique nature and the complex competitive landscape. Note that it is important for SaaS firms to understand the accounting implications of the revenue pricing model. With new accounting rules in place, they now have more flexibility to price revenues competitively.
Need Help With Your SAAS Accounting / Tax?
We at freecashflow.io are an agency that focuses on helping online business owners like you. Our partners have worked in multi-billion dollar MNCs such as Warner Brothers, EY, and paramount. If you want a trusted partner to help you with your tax/accounting, Freecashflow.io is here to help.